Brattle consultants have authored a discussion paper on the effects of recent market turbulence on the cost of capital for European Union (EU) network firms and the implications for regulators in those countries.
European capital markets have experienced two major upheavals in the past five years: the financial crisis of 2009, which resulted in depressed economies worldwide, and the European sovereign debt crisis, which has since manifested itself to various degrees. Both crises have affected the cost of capital for European energy network companies and since tariffs depend on the estimated cost of capital, the way in which regulators account for these recent crises will be critical during upcoming regulatory price controls.
When setting tariffs, regulators are making a forecast of the network’s future beta, which measures the relationship between the market index and a firm’s share price. The financial crisis has passed into history — a similar crisis is unlikely to occur again in the next regulatory period, and so regulators should avoid using data from the 2008-2009 period to estimate the future beta. Since almost all EU energy networks have a revenue guarantee — a shortfall in forecast revenues in one year can be made up the following year – the large decrease in gas and power demand experienced in 2009 had relatively little effect on the share price of network firms. As the stock indices plunged, the share prices of the European networks held up well. This ‘disconnect’ resulted in a sharp decrease in betas for EU network firms. However for several countries the Eurozone crisis has not passed — sovereign spreads remain volatile. This means that for countries that are still affected by the sovereign debt crisis, regulators should only use data from the last two to three years when estimating beta. Failing to do so would underestimate the true cost of capital and result in tariffs that are too low to support investment.
The paper, “A Tale of Two Crises: The Betas of EU Networks,” was authored by Brattle principals Dan Harris and Francesco Lo Passo and is available to download below.